Two or Better: the Rationale behind the Current Ratio

Introduction:?Two to One You’ve Heard of This Ratio

Oscar Wilde offered this opinion about rules of thumb, “It’s absurd to have a hard and fast rule about what one should read and what one shouldn’t.?More than half of modern culture depends on what one shouldn’t read.”?Yet finance relies on a number of rules of thumb—the rule of 72 and the 50/30/20 rule, for example.?Divide 72 by a 6% interest rate, and the resulting 12 is the number of years it will take at that rate for your principal to double.?A country with a 3% population growth rate will see its population double in 24 years.?Elizabeth Warren and her daughter Amelia Warren devised a 50/30/20 for allocating budgets—50% to needs, 30% to wants, 20% to financial goals.?Rules of thumb are expected to provide a shortcut to accurate results, and their use depends on their quick accuracy.

However, not everything lends itself to rule of thumb acceptance.?Rounding Pi from 3.14159 to 3.0 might make the math simpler, but because Pi is used in so many formulas requiring precise answers, the easier calculation does not offer the accuracy needed.?Then there is the 2-to-1 rule of thumb for the current ratio—where did that come from?

It all began in the last few years of the nineteenth century when financial statements became available from borrowers and customers disclosing their assets, liabilities, and net worth.?As early as 1891, the Pennsylvania Railroad Company had divided assets and liabilities into current and non-current sections.?As other firms began to adopt this more detailed breakdown, bankers and creditors started to compare current assets and current liabilities in what came to be known as the current ratio.[i] ?By 1908, one observer reported “Many good judges feel that the ratio of quick (current) assets to (current) liabilities should be about 2 ? to 1.”[ii] Gradually, however, 2 and not 2 ? came to be expected as reasonable protection.?In the case of bankruptcy, falling prices, or inflated figures, the book value of the current assets could shrink 50% in liquidation, and current creditors could still be repaid in full provided there were no long-term creditors.[iii]

As bankers began to expect creditworthy borrowers to have a 2.0x current ratio, borrowers realized that credit would be more forthcoming in they could show their prospective lenders that they had achieved this one financial rite of passage:

The current ratio holds first position among the static (balance sheet) ratios . . . While not in all instances the most important or controlling ratio, it always has a place of prime importance in any analysis.?Moreover, it is a generally accepted ratio, the value of which is universally acknowledged.?In fact, this very acknowledgment and use has in a large measure overemphasized its importance, and all too frequently unsafe credits have been extended because of its preconceived importance as a strength measure, and too many reasonable loans refused because its apparent weakness has scared off an overcautious credit man.[iv]

In fact, the current ratio’s long use as a quantitative measure of financial strength is what we want to re-evaluate by offering some qualitative tools to improve its accuracy.

Cashing in on the Current Ratio:?Current Events

During one of the first loan committee meetings I ever attended, a lender was extolling the credit virtues of his borrower’s balance sheet and proudly pointed out its 2.0x current ratio to which the chief credit officer replied, “So the uncollectible receivables plus the unsaleable inventory add up to twice the sum of the past due trade debt and our delinquent note?”?In a few words the CCO?had pointed out the qualitative deficiencies of relying too much on quantitative measures.?The trade credit agency reports disclosed that the borrower was already on C.O.D. terms with its major supplier which explained the request for an increase in its line of credit.?Inventories were unusually high compared to the previous year, and the receivables aging disclosed about half of its customers were 60 days or more past due despite its stated 30 day terms.?The request also called for an extension of the maturity date to clear the delinquency.?The CCO personally declined the request and transferred the borrower to the work-out group.?

So, there are several ratios that can help in determining the quality of the current ratio (CR) components:

CR Components??????????% of Balance Sheet???????????????Relative to Income Statement

Cash????????????????????????????Cash/Total Assets???????????????????????Cash Turnover = $ Revenues/$ Cash

????????????????????????????????????????????????????????????????????????????????????????Days Cash = 365 days/Cash Turnover

Accts Rec (AR)???????????AR/Total Assets??????????????????????????AR Turnover =?$ Revenues/$ AR

?????????????????????????????????????Days AR = 365 days/AR Turnover

Inventory (Inv)????????????Inv/Total Assets?????????????????????????Inv Turnover = $ COGS/$ Inv

?????????????????????????????????????????????????????????????????????????????????????????Days Inv = 365 days/ Inv Turnover

Notes Payable??(NP)??NP/Total Assets????????????????????????????NP Turnover = $ Revenues/ $NP

?????????????????????????????????????????????????????????????????????????????????????????Days NP = 365 days/NP turnover

Accts Pay ( AP)???AP/Total Assets?????????????????????????????AP Turnover = $ COGS/$ AP

??????????????????????????????????????????????????????????????????????????????????????????Days AP = 365 days/AP turnover

First, look at each current ratio component’s relative size as a percentage of total assets.?For example, if receivables have been running at 30% of total assets in earlier periods, why are receivables suddenly at only 10% or at 50%??The lower percentage might indicate a change in seasonal patterns or more ominously, a decline in sales, and that might explain above-average inventory that is not selling—perhaps it is out of style or obsolescent??For manufacturers, it is worthwhile to look at the amount of inventory in raw materials, work-in-progress, and finished goods because these three categories vary in degree of liquidity.?In liquidation, raw materials probably will be more saleable than the finished goods, especially if the goods are stale, out of fashion, or just last year’s technological toy.?Work-in-progress usually can only be liquidated by spending more to complete them or by tearing them apart to recover some of the material components.?Cost-benefit analysis typically shows neither approach to result in complete recovery of the investment in inventory.

Shifting to the liability side, notes payable and accounts payable reflect who the borrower?is relying on to support the funding of working capital assets.?A common trade term is 2/10/net 30, which generally offers a 2% discount if the customer pays the invoice in the first 10 days of the 30-day credit terms.?Presented with a $1,000 invoice dated December 31, the customer can save $20 and pay just $980 on or before January 10; otherwise the customer has until January 30 to pay the $1,000.?The 2% discount may not seem like a big deal, but it actually works out to be an annual percentage rate of 37% [discount %/ (100%-Discount %) x (365 /(discount days) = 2% (100% -2%) x (365/20) = (2%/98%) x (365/(20) = 1/49 x 18.25 = 37.24% ]?A cost savings of 37% APR justifies borrowing under most lines of credit, and a borrower whose days payable are averaging 20 days is probably taking discounts and is likely to be relying more on its notes payable.?

Note that in calculating inventory turnover and days inventory, we use cost of goods sold (COGS) instead of revenues, and that is because COGS is based on the cost of inventory in contrast to receivables which reflected the sales price of inventory.?For the same reason we use COGS in calculating days payable; trade credit is incurred as the borrower purchases inventory that later is recorded in COGS.?Because the line of credit funds carry of receivables as well as purchase of inventory?and payment of operating expenses, we employ sales.?For the sake of full disclosure, you will find some spreading programs dispense with the niceties of?distinguishing between revenues and COGS and just use revenues, partly because service industry borrowers do not always break out cost of sales.

Another helpful approach is to compare?the borrower’s results with industry averages, and the Risk Management Association’s Annual Statement Studies have been around for a century dating back to the work of RMA’s Alexander Wall and Raymond Duning, whose 1928 Ratio Analysis of Financial Statements was based on their observations of the data collected annually from RMA member banks.?Given that member banks submit financial statements received from their current borrowers, the data offers insight into what bankable clients’ financials look like.

Here is an example of the application of industry measures in?evaluating?a borrower’s current ratio components[v] :

Current Ratio Components*?????????????????????????Borrower Financial Data RMA Industry[vi]

Component????????????????Measure?????????????????????????FY’06????FY’07???????????????????2006??????????????2007

cash???????????????????????????cash/total assets %???????????6.1????????6.5???????????????????????7.7????????5.8

Accts Rec??????????????AR/TA %?????????????????????????18.5??????15.4?????????????????????14.7??????????????15.0

Inventory???????????????????Inv/TA %??????????????????????????24.0??????27.6?????????????????????28.6??????????????28.1

Current Assets??????????Tot CA/TA %????????????????????50.6??????50.8?????????????????????54.8??????????????52.4

Accts payable????????????AP/TA %???????????????????????????9.0????????9.5????????????????????11.0??????????????10.3

Notes payable???????????NP/TA %???????????????????????????14.4??????13.3?????????????????????11.4??????????????11.3

AR turnover??????????????days receivable??????????????37?????????29????????????????????????26??????????????25

Inventory turnover????days inventory????????????????68?????????76????????????????????????90??????????????92

Payables turnover?????days payable???????????????????23?????????25????????????????????????26??????????????23

*Current Ratio??????????CA/CL?????2.2 2.2 2.4 2.4????????????????????????????????????????????

The borrower’s current ratio has stayed a little below the industry, but it has been a constant 2.2x, so the quantity is up to snuff, but what about the components.?Inventory levels are slightly below the industry averages but rose in FY’07 while its receivables levels have decreased to just a little above industry levels.?The days ratios offer more insight—the borrower’s receivable turn more slowly which explains the above-average receivables level, but the faster inventory turn has resulted in below-average inventory levels.?Funding these working capital assets has been more from bank debt than trade debt although the trend looks to be leaning a little more toward accounts payables and a little less to notes payable.?This analysis is a mostly good news story—slightly lower-than-average current ratio, but still over 2.0x, and the components are generally in line with the industry averages.?The lower inventory levels coupled with the faster inventory turnover may have expanded receivables a tad more than industry averages, but the sharp decline in receivables turnover suggests the borrower’s credit collections are digesting the extra receivable.?Even better, converting the inventory into receivables is a positive step toward more working capital liquidity.

Summary and Closing:?Crude But Still Used

Sixty years ago, three Harvard MBA professors described the current ratio this way:?“Despite its wide use –which analysts suggest its use is revealing—the current ratio is at best a very crude measure of the financial health of a firm and its ability to meet its debts . . . inventory is included in current assets . . . the inventory may be of limited salability, particularly in the short run.”[vii] One of the goals of this piece has been to demonstrate that the current ratio has been around for a long time, and its weaknesses duly noted by finance professionals.?The other objective has been to remind readers that a rule of thumb such as a 2.0x current ratio is exactly that, an acceptable shortcut as long as it works.?Inventor Tom Edison admitted, “There are no rules here—we’re trying to accomplish something.”?An accomplished analyst knows that, and so should you readers.?????????????????

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[i] Roy A. Foulke, Practical Financial Statement Analysis, Fifth Edition, McGraw-Hill Book Company:?New York City, 1961, pp.178-181.

[ii] William M. Rosedale, “Credit Department Methods,” Bankers Magazine, Vol. LXXVI, No. 2, p. 187, February, 1908.

[iii] Foulke, op. cit.

[iv] Alexander Wall and Raymond W. Duning, Ratio Analysis of Financial Statements: An Explanation of a Method of Analysing Financial Statements by the Use of Ratios, Harper & Brothers:?New York City, 1928, pp. 107-8.?Wall and Deming were officers of Robert Morris Associates, now the Risk Management Association, and responsible for establishing RMA’s Annual Statement Studies ?in 1914.

[v] “The Impact of Working Capital Investment on the Value of a Company,” The RMA Journal, April 2003, pp.48-55

[vi] Risk Management Association, Annual Statement Studies, 800-677-7621 or www.rmahq.org

[vii] Pearson Hunt, Charles M. Williams, and Gordon Donaldson, Basic Business Finance, Third Edition, Richard D. Irwin, Inc.:?Homewood, Illinois, 1966. p. 146.